A House hearing for a top Fed regulator turned into a figurative passing of the gavel from Republicans to Democrats.

Randal Quarles is the Vice Chairman for Supervision and he was testifying in front of the House Financial Services Committee in his bi-annual testimony on November 14, 2018.

The current chair of the House Financial Services Committee- which is the most important committee on Capitol Hill to the trading world- is Jeb Hensarling, a Republican from the State of Texas, but as a result of the November 6 election, Democrats will be taking over the committee since they now control the House of Representatives.

Hensarling used his opening statement to acknowledge this fact, congratulating the Democrats on their win

“I will do everything today to ensure there will be an efficient and peaceful transfer power.” Hensarling said. “The majority side stands ready and prepared to everything possible for there to be an efficient and peaceful transition of power on this committee.”

While committee assignments have not yet technically been released for the next Congress, it is a foregone conclusion that Maxie Waters, a Democrat from the State of California and the current ranking member, or chief of the current minority, will be taking over.

Jeb Hensarling

“I would like to acknowledge the ranking member’s long-time participation on this committee.” Hensarling said.

Hensarling is retiring and he leaves his Chairmanship with significant accomplishments.

While Republicans have not outright repealed Dodd/Frank, in May 2018, President Trump signed into law the Economic Growth, Regulatory Relief and Consumer Protection Act, which significantly reformed it.

This law started as the Financial Choice Act and passed out of the House Financial Services Committee; a deal was negotiated when the bill reached the Senate, leading to the final product.

One reform not part of the new bill is the so-called Volcker rule, which remains in place.

The Volcker rule, which forbids banks for engaging in proprietary trading, has been blamed by Hensarling for illiquidity in the corporate bond market, which trade over the counter; banks, who make markets in these bonds are in many cases considered to be engaging in proprietary trading and forbidden.

While Hensarling was not able to replace that rule, his continued criticism throughout the past two years were the initial spark for an issue which eventually received plenty of debate.

The Federal Reserve is one of five regulators, and they are looking to reform that rule as well.

During his turn to ask questions, Hensarling asked Quarles, “In your tenure on the Fed, have you concluded if there a nexus between fixed income markets volatility and illiquidity and the Volcker rule?” Hensarling asked?

“I think it’s inarguable from the experience of markets participants,” Quarles answered, saying in effect, that the rule was making these markets more illiquid.

When Waters took her turn, she clearly laid out where the ideological battle will be fought over the next two years.

“I do feel it is appropriate to discuss Dodd/Frank and the harmful effects of the current committee majority to weaken and rollback parts of this law.” Waters said.

The Economic Growth, Regulatory Relief and Consumer Protection Act, which aimed to reduce and streamline regulations, was part of a larger effort by President Trump to do the same with all regulations.

That is generally supported by his party and opposed by Democrats.

On financial regulations, specifically, Democrats generally believe that the 2008 financial crisis showed that financial companies were in desperate need of more regulation while Republicans saw Dodd/Frank and other legislative and executive ideas as massive over reach.

Indeed, it’s noteworthy that Dodd/Frank was responsible for Quarles position at the Fed, when that law mandated the creation of this position.

Democrats have long argued that the Fed needs to take a more active role in regulation and enforcement and that portion of Dodd/Frank aimed to fix this.

Republicans, on the other hand, argue that this creates yet another regulator, who is only overlapping with other regulators to create confusion; the Federal Reserve is one of five regulators with oversight over the Volcker rule.

Waters represents an area of Los Angeles County which is much more liberal than the US itself; Waters is virulently anti-Wall Street and by extension anti-trading.

But her effect on the industry is not clear, first, this is the age of Donald Trump, where almost nothing is predictable.

Second, as the chair of the Financial Services Committee, she has certain powers, but she can’t impose a left-wing agenda.

Laws she’d like to impose have no chance of getting through the Republican led Senate, nor would the President ever sign them.

As such, anything which could pass must be done through deal-making.

Carolyn Maloney

Another powerful person in the committee will be Carolyn Maloney, a Democrat from the State of New York.

She is currently the ranking member of the most important sub-committee for traders, the Capital Markets, Securities, and Investment sub-committee; she is likely to become chair of that or another powerful sub-committee.

There will be many proxy wars fought in the House Financial Services Committee over the direction of regulation and one will be over the so-called stress tests.

“Very painful to many of us the memory of a financial crisis where we lost $13 trillion of household wealth, nine million jobs, millions of homes and unemployment was at ten percent.” She said. “Bank profits are now higher than they’ve ever been, $173 billion, I believe the highest ever. So, we’ve bounced back. The banks are good; the economy is humming, but I’m very concerned about any effort to roll back the stress test.”

The bank stress test “is an analysis conducted under hypothetical unfavorable economic scenarios, such as a deep recession or financial crisis, designed to determine whether a bank has enough capital to withstand the impact of adverse economic developments. In the United States, banks with $50 billion or more in assets are required to do internal stress tests by their own risk management team as well as by the Federal Reserve.” According to the website Investopedia.

The current chair of the Capital Markets, Securities and Investments sub-committee is Bill Huizenga, a Republican from the State of Michigan.

During his question and answer period, Huizenga also took aim at the Volcker rule, “Needless, to say, many people believe the Volcker rule was a solution in search of a problem.”

Quarles for his part emphasized the theme of transparency, using that word repeatedly.

“Transparency is part of the foundation of public accountability and a cornerstone of due process. It is also key to a well-functioning regulatory system and an essential aspect of safety and soundness, as well as financial stability.” Quarles said in his written comments.“Transparency provides financial firms clarity on the letter and spirit of their obligations; it provides supervisors with the benefit of exposure to a diversity of perspectives; and it provides markets with insight into the condition of regulated firms, fostering market discipline. Transparency increases public confidence in the role of the financial system to support credit, investment, and economic growth.”

A recent Presidential tweet may have reverberations in the securities world.

“In speaking with some of the world’s top business leaders I asked what it is that would make business (jobs) even better in the U.S. ‘Stop quarterly reporting & go to a six month system,’ said one. That would allow greater flexibility & save money. I have asked the SEC to study!” President Trump tweeted on Friday.

In speaking with some of the world’s top business leaders I asked what it is that would make business (jobs) even better in the U.S. “Stop quarterly reporting & go to a six month system,” said one. That would allow greater flexibility & save money. I have asked the SEC to study!

The idea was quickly met with support from the Chairman of the House Financial Services Committee, Jeb Hensarling who quickly issued a statement.

Jeb Hensarling, Chairman of the House Financial Services Committee

“I applaud the President’s continued efforts to evaluate the impact and cost of federal regulation on American businesses and entrepreneurs. In order to sustain 3% economic growth and ensure we are able to compete with China, we must modernize our capital markets regulations in a way that maximizes economic growth while maintaining the transparency and accountability needed to protect investors.” Hensarling stated. “The bipartisan ‘JOBS and Investor Confidence Act of 2018,’ which passed the House with near unanimous support in July, would do just that. I urge my colleagues in the Senate to support small businesses, entrepreneurs and investors by passing JOBS Act 3.0.”

That bill, according to the House Financial Services Committee, would require “the SEC to provide a report to Congress with a cost-benefit analysis of reporting companies’ use of SEC Form 10-Q, which companies use to report information every three months, as well as recommendations for decreasing costs, increasing transparency, and increasing efficiency of periodic financial reporting by EGCs (Emerging Growth Companies).”

“This is the exact issue I was afraid of when people boasted about DJT’s business acumen. He never ran a public company and doesn’t know a thing about being held accountable to the public. Quarterly reporting is a must to keep business accountable to share holders!” said another.

Corrupt Donny always in favor of less transparency to favor billionaires with inside information over shareholders playing by the rules. #TrumpSwamp

While mortgage securitization is critical to house financing reform, the path to get there remains a matter of debate.

The House Financial Services Committee has touted two different proposals.

One was put forward by the chairman, Republican Jeb Hensarling from the State of Texas, during a speech on the future of housing finance.

“Comprehensive housing finance reform remains the great financial services challenge of our time, an elusive $14 trillion question in search of the political courage to answer it. But courage must be mustered, memories of the second worst financial crisis in our history cannot be allowed to fade. After all, we saw median household incomes climb to a peak of more than $58,000 in 2007, before cratering and not regaining that lost value until last year. In other words, a lost decade.” Hensarling stated.

In the same speech, Hensarling went on to lay out his support for the PATH Act: “It [a new house financing system] would need to promote long-term stability and prosperity by decreasing the crippling volatility that has destroyed so much household wealth. It would effectively protect taxpayers against future credit risk. In my mind, there is already one proposal out there that would accomplish all of those goals and then some: the PATH Act passed by the Financial Services Committee in the 113th Congress.”

The PATH Act would wind down the two Government Sponsored Entities (GSEs) – Fannie Mae and Freddie Mac. These two mortgage giants underwrite mortgages which are then securitized as mortgage bonds.

Hensarling noted that by eliminating Fannie–Freddie, a new paradigm for mortgage securitization would emerge, “It also builds on existing elements of our current system – a right-sized FHA, an independent and open common securitization platform, and transitional GSE financing – as well as providing new and enhanced ways to finance mortgage lending via greater portfolio lending, privately securitized transactions, and new covered bond options.”

Fannie Mae and Freddie Mac were created by the government but are publicly traded companies – both are now traded over the counter. They went into government receivership when accounting fraud and toxic loans forced both to need tens of billions in government funds and loan guarantees.

Among the witnesses was Dr. Michael Carter, Director of US Multi-Sector and Securitized Assets, at Alliance Bernstein L.P.

Dr. Carter, unlike Hensarling, argued that the GSEs should continue to securitize loans, but that reform comes from a process known as credit risk transfer (CRT).

“I view the process of Housing Finance reform as a continuum, noting that the Government Sponsored Enterprises that are at the center of the housing finance system and their regulator the Federal Housing Finance Agency [FHFA] have already made some progress in reforms post-crisis most notably through the introduction of the Credit Risk Transfer market. CRTs are debt issuances with payments linked to the credit performance of an underlying pool of loans, and they provide a layer of private capital as well as a source of market pricing of risk that the GSEs had lacked pre-crisis.”

A white paper by Voya Investments outlined how CRTs work and how they differ from previous methods of mortgage securitization: “In the wake of the crisis the FHFA outlined a strategic plan to reduce the risk posed to tax payers from Fannie Mae and Freddie Mac. As part of this plan, a primary challenge emerged: how to reduce risk to the U.S. tax payer and the financial system, but do so in a way that preserves efficient and reliable borrower access to mortgage credit. To assist in meeting this challenge, the ‘Credit Risk Transfer’ securitization market was created.

“After years of planning and consultation with capital market participants and regulators, CRT issuance commenced in 2013. Both Freddie Mac and Fannie Mae issued publicly registered securities, via Structured Agency Credit Risk (STACR) and Connecticut Avenues Securities (CAS) transactions. With the successful issuance of these fixed income instruments, the GSEs effectively purchased protection against potential default risk from their mortgage borrowers via capital markets investors. The GSEs continued to collect their normal guarantee fees from lenders for covering borrower credit risk, but now compensated investors in STACR and CAS transactions for taking portions of that same risk.”

Dr. Carter said, “Today the CRT market has $40 billion of securities outstanding referencing over $1.3 trillion of mortgages; that’s 32% of the GSE’s overall mortgage exposure. In fact, 50% of all GSE mortgages created today go into CRT transactions. So, without a doubt the CRT bond market is crucial to how mortgages get financed in the country.”

Dr. Carter continued by noting that securitizing mortgages – or turning mortgages into bonds – was the key to any house financing reform: “We see the fixed income market solution as the cornerstone to any system going forward.”

Dr. Carter listed several reasons why securitization is so critical 1) all mortgage bonds are fully funded, “there is no counterparty risk; there is no risk of non-payment.” 2) risk in bond form can be spread to a large number of people and entities 3) CRT bonds pay immediately and on a set schedule.

Dr. Carter contrasted this with using mortgage insurance (MI) to spread risk.

Currently, mortgage insurance is primarily used on loans where the loan-to-value ratio (LTV) is more than 80% of the value of the home. Dr. Carter noted that some proposals would reduce this figure – he referred to this as “Deep MI.”

With MI, a mortgage insurance company adds a monthly mortgage insurance payment on top of the regular mortgage payment and then guarantees the loan if it is defaulted.

In contrast, the use of MI to spread risk carries risk. “It is important to remember that the ability and willingness of MI companies to pay claims becomes highly questionable during times of stress; it certainly did during the crisis [2008 financial crisis].”

Dr. Carter also noted that there are only eight MI companies in existence, a stark contrast to the millions of traders and investors willing to buy mortgage bonds.

Reform would allow “the GSEs to take risk alongside the investors. This alignment of interest has been crucial to investor’s comfort in buying CRT securities,” Dr. Carter said. “The GSEs are trusted by investors for the power they have for not only setting underwriting and servicing but insuring they are enforced.”

Dr. Carter noted, without mentioning the PATH Act, that investors would not have the same confidence in a new set of mortgage securitizers, as the PATH Act imagines: “Such confidence, however, would be difficult for any new guarantors to develop.”

It is noteworthy that one of the reasons the financial crisis occurred was because this confidence was misplaced; both the GSEs loosened their underwriting standards until trillions in toxic loans filled the mortgage bonds. While Dr. Carter argues that secondary mortgage buyers have confidence in the GSEs, they may not have in new securitizers, it is also just as likely that, given their history, secondary buyers do not have this confidence.

He also argued that when competing against each other, the GSEs innovate: “There has been a healthy competition between the GSEs for investor dollars. This dynamic has allowed for innovation.”

With Fannie and Freddie dominating the market, that leaves only two companies to compete: a dynamic Dr. Carter took note of: “In my mind, there is no magic number of guarantors for the new system, but I think it is safe to say it is more than two.”

Chairman Hensarling recently announced he would be retiring when his term ends in 2018.

The Housing and Insurance sub-committee is chaired by Sean Duffy, a Republican from the State of Wisconsin.

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